As part of the growing movement to recognise environmental, social and corporate governance (ESG) risks, the concept of externalities has become increasingly relevant. The English economist Arthur Pigou was one of the first to develop the idea of externalities in the early 20th century, pointing out that sparks from railway engines sometimes ignited nearby woodlands or farmland, destroying timber or crops. Because the owners of the land received no compensation for the damage caused, neither the railway companies nor their customers recognised the social costs associated with their transaction.

The externalities of greatest interest in contemporary discussion typically fall under the E, S and G headings. However, this leaves a critically important externality – that of asset mispricing – largely ignored. As well as polluted air, we have polluted asset prices. In this case, the offending parties are asset management strategies that are driven by prices rather than cashflows, contributing to destabilising positive feedback effects and chronic mispricing.

Adherents of efficient markets thinking will argue that the extent of asset mispricing is so small as to make any negative spillover effects trivial. But the existence of asset price bubbles, large and persistent profits to simple momentum strategies, and the inversion of risk and return across many asset classes (often described as the low volatility anomaly) completely undermines the picture of markets as more-or-less efficient.

If we instead accept that financial assets can be mispriced, and at times severely so, then it is worth considering what economic damage might result from this source. We can think about this at two levels: at the macro level of asset price bubbles and at the micro level of corporate decision-making.

Asset price bubbles are the ultimate manifestation of mispricing and are widely regarded as economically disruptive. However, the conventional wisdom in central banking – epitomised by the Greenspan doctrine – had been to use monetary policy to limit the damage after a collapse in asset prices, rather than attempting to head off the damage as a bubble inflates. This view remained intact in the aftermath of the Tech bubble of the late 90s, but was fundamentally challenged by the experience of the financial crisis. In a speech in 20091, Janet Yellen said that “not dealing with certain kinds of bubbles before they get big can have grave consequences. This lends more weight to arguments in favour of attempting to mitigate bubbles, especially when a credit boom is the driving factor.” It remains to be seen to what extent central bank policy will embrace this more interventionist mindset and how effective the approach will be.

While less obvious than asset price bubbles, the damage done by the impact of mispricing on corporate decision-making may be just as great. If prices do not reflect fundamental value, corporate executives are faced with a dilemma: do they maximise the share price in the short run or cashflows in the long run. In the presence of lucrative share option schemes, many choose the former. There has been much hand-wringing over the causes and effects of corporate short-termism, with the focus often on egregious compensation packages or the problems of quarterly earnings guidance. But the effects of asset mispricing on the private sector have received relatively little attention.

Asset owners have an opportunity to reduce both the macro and micro level social costs described above through their investment strategy choices. As we have argued elsewhere, investment decisions based on past price movements, as opposed to a thoughtful assessment of future cashflows, can cause asset prices to depart substantially from fair value. Common examples of price-only strategies include momentum and trend-following, tracking error constraints, and procyclical performance-chasing by both asset managers and asset owners. Performance-chasing is more a by-product of career risk considerations than an explicit strategy choice, but nonetheless deserves more attention than it typically receives. By identifying and removing such strategies from their portfolios, asset owners could help reduce the feedback effects that contribute to asset mispricing and thereby reduce the externalities that accompany it.

Amidst the broader shift in attitudes towards business – with a greater expectation that companies should behave in a socially responsible and sustainable way – investors need to be cognisant of the externalities that arise from their investment approach (and not just from the underlying companies they hold). Attention has so far been directed towards environmental and social issues, but over time, questions will increasingly be asked of the social utility of various aspects of finance – especially if financial market excesses contribute to an economic downturn in the years ahead. Asset owners and asset managers therefore have good reason, on both private and social grounds, to review the wider impact that their investment approach has on the world around them.

Footnotes


1. Janet Yellen, A Minsky Meltdown – Lessons for Central Bankers, 2009

Our Blog

View All

of our latest blogs

The transparency fallacy

One of the recommendations emerging from the recent CMA review into the investment consulting marketplace is for greater transparency around fiduciary manager performance. The resulting proposal has garnered almost universal support, but may create some damaging unintended consequences.

Tell Me More

Chapter 12 for the 21st century

Chapter 12 of Keynes’s masterpiece The General Theory has long been recognised as a brilliant articulation of the tendency towards short-termism in financial markets. In this post, we outline some of the parallels between the ideas contained in Chapter 12 and the research that motivates our work at Ricardo Research.

Tell Me More